Pirelli: a fiduciary management case study

One year ago Flavio Cateni, finance director of Pirelli UK and chair of trustees of its pension funds, told Pensions Week of his frustration with the traditional investment management role for pension schemes.

The creation of a £600m common investment fund for the four Pirelli schemes representing 10,000 members had not worked as well as he hoped.

“The structure worked to a certain extent when the financial markets and the financial reality was not so complex, but when the market was more complex this was not simply enough,” he said at the time.

An example of his frustrations was the 18 months of due diligence and trustee training that it took to agree to an interest rate swap, by which time it had become cheaper to use gilts.

The solution, the trustees decided, was a fiduciary manager and after a search of the market, Cardano was appointed.

So one year on, how has the relationship fared? It would be interesting to report that the funding position has dramatically improved, but due to the decline in gilt yields it has not. But equally it has not worsened like many other schemes.

Furthermore, Cateni says all the hedges mean the volatility of the funding position is likely to be a thing of the past. This is something that should be beneficial for the valuation of Pirelli as a listed company.

Cateni explains the stability brought from new inflation and interest rate hedges will avoid analysts and ratings agencies from factoring in the worst case scenarios of more volatile funding levels.

This will be especially true from January when new stricter accounting rules for pension deficits come in.

“A deficit that could be lower or even greater is always a question mark. And every time there is a question mark it means that third parties, the analysts, the rating agencies, will take the pessimistic view on this, more than what it is fair to assume.

Faced with the high degree of complexity of the matter, they will evaluate the company on one scenario: the most prudent possible. So, it is better to have the deficit fixed than to have this question mark.”

Under the advice and direction of Cardano, the Pirelli schemes have brought in an interest rate hedge for a third of their funds, with a swaption for another 35 per cent. Inflation is hedged to 80 per cent of liabilities through instruments such as synthetic break-even inflation hedging.

Volatility in investments has also been halved by reducing equities from 60 per cent to a 10-15 per cent range and the expansion of a range of fixed income and hedge fund strategies, including macro-oriented and multi-strategy funds.

Over the past year the hedging, as much as asset allocation decisions, has been the key factor.

“We would have surely been in a worse position if we had not implemented,” says Cateni.

“Before we were not hedged at all, against inflation and on rates; we just had some rough hedging, 15 per cent in government gilts, but that was not really their purpose.”

Not surprisingly, the trustee board is feeling pretty smug about the new arrangements and it is not just down to the funding position, but also the sense of control.

“The trustees are feeling the exhilaration at the route we have taken. They are understanding more and more of the financial instruments and all the tools we are implementing.

And the more they learn the more they want to be involved. Which is not something you find easily in the pension world,” adds Cateni.

“Things are moving much faster. We have done much more in the past 18 months than we have done in the previous five years, because we have been properly educated and we have a proper guide and there are clear rules and responsibilities.

“We feel much more aware of the possibilities that are out there in the market. Concepts that were exotic or impenetrable a year ago, now look much less threatening. We feel much more in control of our destiny.

“We do not pretend to know every aspect of the financial world but at least we are reducing the known unknowns. Step by step we are increasing our awareness.”

It is worth drawing breath here to look at the arrangement Pirelli’s schemes have with Cardano. One might assume everything is delegated, but that is not the case.

While Cardano’s mandate is largely fully delegated within agreed guidelines, it is advisory on some of the more complex liability hedging.

One of the decisions trustees are pondering is what to do with the collar swaption put in place to partially hedge the interest rates for 35 per cent of the portfolio. This expires after one year and the trustees will have to decide whether to simply wait or sell it, replacing it with a new swaption.

This process might sounding daunting and it is an indication that having a fiduciary manager is not necessarily less work than working with a conventional investment consultant.

“Fiduciary management has a lot of challenges, and this absorbs more than the time that is freed up by not having to do the low value activity such as the hiring and firing of asset managers, the beauty parades,” says Cateni, who notes that even then the trustees often regret not always having enough time to go through all the details in the reports Cardano provides.

There is also the task of learning how to effectively monitor a fiduciary.

Cateni splits this role into four responsibilities, or controls, as he puts it.

1) To what extent is the fiduciary manager achieving the given targets? How is their compliance with the risk range given to them?

2) What tools and which investment strategies are they using? How is the fiduciary spending the allocated risk budget? “This is one of the most complicated areas,” says Cateni.

3) Are the shown metrics true? Trustees should ask how much is performance down to the market, how much is due to luck and how much is due to skill; they should also ask if they could have reached the same results with alternative strategies.

4) What strategies is the fiduciary manager proposing for the next 10-15 years? Do they really translate in the risk metrics shown?

What might surprise some is that the Pirelli trustees have not yet brought in an external adviser, the likes of which are provided by companies such as KPMG, Ernst & Young, Muse Advisory and Hymans Robertson.

“We are thinking of asking for some help from an external basis,” says Cateni. “To understand the risk budget on an ex ante basis you need a professional there to give you a better understanding.

“We can ask our actuaries to make some checks, we can ask our custodian to make some checks on the performance. We will see as time goes on if we need to hire a professional investment adviser.”

So has there been any disappointments? Cateni says it is too early to make a judgment on Cardano. “Our recovery plan is 10-15 years so we are only one year in that direction,” he says, but it all seems a very promising start.